LIBOR (London inter-bank offered rate) will be phased out by the end of this year and borrowers must act now to agree the transition process with their lenders and hedge counterparties. But what is the best approach when lenders’ and hedge counterparties’ transition processes are moving at different speeds?
Although some progress has been made, discussions on LIBOR transition to an alternative ‘risk-free rate’ (RFR) – currently SONIA (sterling over-night indexed average) for the UK – remain fragmented. Indeed, even within individual institutions, we have seen inconsistent messaging to customers.
By now, lenders and hedge counterparties should have contacted their customers to discuss LIBOR transition to an RFR and update existing fallback clauses (or the lack of them) in all financings and hedges that reference LIBOR. However, borrowers complain that the more information they receive about LIBOR transition, the more questions they have.
One common concern is the progress made in the debt market, which lags that of the derivatives market. With this in mind, how can borrowers ensure there is no mismatch between their interest rate hedge and the underlying debt?
This can have wider implications for those who apply hedge accounting in the form of added scrutiny from external auditors and the potential for hedge accounting ineffectiveness.
The International Swaps and Derivatives Association recently published its protocol, which governs derivative products and standardises the approach across all existing LIBOR-referencing products, but nothing similar has yet been published to govern the loan markets.
Where some drafts have already been issued by the Loan Market Association, this has been mainly for syndicated loans.
Another concern we often hear is the operational challenge for treasury teams who will not know the interest payment until a few days before the end of the interest period.
This has prompted discussion around the use of Term SONIA instead, which is designed to be a forward-looking RFR alternative to LIBOR. On the surface it appears to address this issue, but it is not that straightforward. One problem is that Term SONIA relies on SONIA being a liquid and transparent market and the danger is a wider use of it would rob the SONIA market of that liquidity.
At the same time, banks are at different levels of SONIA preparedness. Some can offer loans and hedge products referencing a replacement RFR; others are able to offer loans that reference SONIA but not offer the derivative to hedge any associated interest rate risk. In some circumstances, this can be explained by a lack of communication within the bank itself, not helped by latent corporate bank versus investment bank rivalry.
We have also noticed that some lenders offer alternative funding options such as floating rate loans linked to Bank of England base-rate or fixed-rate loans, although this is not an option offered to all borrowers.
One slight concern is that we have seen some banks offer a wider selection of options to some borrowers but not to others, which could lead to adverse outcomes for those with a limited choice.
In addition, some foreign lenders and banks operating in the UK in the real estate sector, for which their main operations abroad are not undergoing benchmark transitions, are communicating to their borrowers that they do not plan to tackle this issue until the end of the year, which may compound the uncertainty and nervousness for UK-based clients. This will particularly impact syndicated loans, as all lenders need to agree the approach.
Our advice amid this confusion? Be on the front foot. Every bank and borrower will need to do something with existing LIBOR loans/hedges before 31 December 2021. The first step is to identify where you have LIBOR exposure and decide your best case outcome. Be part of the conversation and shape your LIBOR transition, otherwise it is in danger of being shaped by others.
There could easily be a stampede for the exit as the deadline approaches, which may impact the transition process. Importantly, there will be a credit adjustment spread added to any replacement RFR, so be sure to avoid any unintended transfer of value. Engage with your lenders and hedge counterparties now, and seek commercial (not just legal) advice on the implications of this for you.
Rhona Macpherson is senior consultant at Vedanta Hedging